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The Mortgage Crisis and Expert Systems for Due Diligence

Expert systems can serve as effective tools to improve the due diligence process for real estate transactions (and actually for all types of transactions including mergers and acquisitions). Expert systems provide users with the knowledge of experts on how to deal with a specific problem or series of related problems. For example, in the real estate finance sector such a system can focus on whether certain documents affecting a parcel of real property create issues that have a material effect on the value of the parcel of property. Expert systems are built on the knowledge of experts in the particular field, including the knowledge of how to solve the subject problem reasonably and efficiently.

While expert systems are useful tools for managing due diligence for all species of real estate transactions, their implementation and use also can be one step to take to regain the confidence of investors in the quality of securitized loans—whether used by lenders, purchasers, rating agencies, or regulators.

Clearly, the investment community’s loss of confidence in commercial real estate mortgages produced by conduit lenders is a major factor in the increased yield requirements demanded by purchasers of interests in such mortgages. To a great extent, this decline in trust comes from the debacle in residential mortgages. Conduit lenders were producing residential mortgage loans that should never have been made if sound loan underwriting requirements were being followed. Many shortcuts were taken in the lending process to produce a volume of loans sufficient to satisfy the voracious appetite of the investment community for interests in large pools of residential loans.

Although the commercial mortgage loans produced by conduit lenders have not resulted in significant delinquencies (at the time I am writing this column in October 2008), the investment community has become skeptical about the quality of commercial mortgage loans produced by the same group of conduit lenders that have produced troublesome residential loans. Any problems with the underwriting and due diligence of commercial loans will not surface until the loans are examined (1) for delinquencies, (2) for sales of the loans or of interests therein, or (3) reviewed by regulators and/or rating agencies. Because of the great volume of loans to examine, it is not clear how deep such examinations will go.

To understand the need for additional rigor in the due diligence process, consider the environment in which the loans were made. Commercial mortgage lenders were in a very competitive environment. In particular, conduit lenders (as opposed to lenders making loans for their own portfolios) that made loans for the purpose of placing them into large pools of loans, the interests in which were intended to be sold primarily to institutional investors, wanted the greatest volume possible because they made their money on the fees earned. The more loans, the more earnings. To be competitive, the rate of interest is obviously important, but the service provided to borrowers is also critical. Lenders’ reputations in the borrower community are generally enhanced by quick turnaround times and quick closings. Lenders do not want their reputations to be damaged by taking too much time to approve any facet of a commercial real estate transaction.

Many due diligence elements come into play when originating a commercial mortgage loan. They include, but are not limited to, the review and analysis of (1) the value of the property, (2) the credit of the borrower and other material parties (such as guarantors of the borrower and certain significant principals of the borrower and guarantors), (3) title matters, (4) survey, (5) leases, (6) material contracts relating to the operation of the property, (7) zoning, (8) environmental conditions, (9) litigation affecting the property, the borrower, or other material parties, (10) insurance on the property, (11) the physical condition of the land and all improvements, and (12) the documentation relating to the formation and operation of the borrower and other material parties.

Some due diligence items referred to above are part of the underwriting process performed by business analysts, such as the credit of the borrower and the value of the subject property. The lender’s lawyers tend to review title, leases, contracts, and entity documentation. The lender has other experts review zoning, environmental, and property conditions, although the lawyers may participate in these reviews based on the particular circumstances or preferences of the lender. A primary purpose of the legal review is to determine if the documents or conditions being reviewed have a material effect on the value of the subject real property.

With the need for quick turnaround times and quick closings for lenders to remain competitive and the expectations of the various parties that approval is only a few seconds away by e-mail or notation on a transaction website, there is a great deal of pressure to perform all due diligence to meet the tight schedules for closing the loan.

The focus of the balance of this column is on the due diligence performed by the lawyers. That is not to suggest that the due diligence performed by the business people and their other experts could not benefit from the use of an expert system. Clearly, it can.

The lawyers are under great pressure to meet the time requirements of their lender clients. If they fail to meet the target dates for performing their required tasks without good cause (and some lenders might not be willing to recognize good cause), they face the possibility that their client will use another firm. The lawyers are also under pressure to keep their fees at a competitive level. In almost all cases, it is the borrower that pays the lender’s counsel fees, but a lender’s competitive position will be adversely affected if its counsel fees are regularly greater than those of the competition. Clearly, some law firms have recognized this and established very efficient operations by adopting effective processes for performing due diligence in a timely manner.

Generally, the legal due diligence work is not performed by the most knowledgeable lawyers working on the transaction. Often the work is done initially by a paralegal or junior attorney who is in the process of building his or her real estate knowledge. Their work will most likely be reviewed by an experienced lawyer. Typically, the experienced lawyer does not have the time to repeat the initial work. If that time were available, there would be no reason for the initial review. The possibility exists that, because of the time pressures on the initial review and on the review of the more experienced lawyer, certain critical issues will not be spotted. Because of the pressure to meet a deadline, the lawyer and paralegal (no matter how experienced and knowledgeable they are) may overlook things learned from experience, training seminars, and discussions, or from reading books, memos, and other materials. Not everything is remembered at every moment, particularly under the pressure to meet a deadline.

So how can an expert system help improve the due diligence process? I can give the example of one I developed for reviewing leases. After a more than 30-year career in negotiating, drafting loan documents, and performing due diligence for commercial mortgage loans for a large institutional investor, I spent a period of about two-and-a-half years reviewing leases for law firms representing large conduit lenders until the conduit lending market collapsed. During those two-and-a-half years, I reviewed more than 700 leases.

To enhance my productivity and ensure quality and consistency, I developed an expert system to facilitate lease review. (I should note that I had also developed a couple of expert systems during my career with the institutional investor—for both commercial mortgage loans and residential loans.) As a result, I significantly reduced the time to review a lease and prepare a lease summary. I built into the system a good deal of knowledge to reduce the possibility of failing to consider certain issues that were not specifically addressed in leases. Believe it or not, some leases fail to contain default, condemnation, and other significant provisions. Generally, lenders identify how certain significant issues are dealt with in the lease and whether any additional issues should be brought to the lender’s attention. Some of those additional issues may arise because of special provisions added to the lease or by the omission of provisions that would ordinarily be expected to be present in the lease. Such expected provisions vary depending on the type of project, such as a shopping center, office building, or warehouse; the size of the project; whether the property being leased is a building, space in a building, or land on which the landlord or the tenant is to construct a building; or other factors. The system allowed me to review the lease from beginning to end and to identify issues as they arose in the lease without requiring that I address issues in any specific order. After reviewing the lease, the system would prepare a lease summary in the format desired by the lender (the system would automatically alter the format depending on which lender requested the review) and a transmittal letter that highlighted the most significant issues noted during the review process.

Such a lease review system is even more valuable when a paralegal or a lawyer in the early stages of his or her career is doing the review. The system can (1) identify issues that they might not otherwise recognize, (2) answer questions for them that they might otherwise have to wait to discuss with a more experienced lawyer (who might be unavailable because of meetings, negotiations, business travel, vacation, illness, or otherwise), and (3) point out that an experienced lawyer should be consulted on certain specified issues before considering the review complete. In this way, such a system is also a useful training tool.

The bottom line for such a system is (1) to increase productivity by reducing the time necessary to complete the lease review, (2) to increase quality by reducing the possibility that significant issues might be overlooked, and (3) to increase consistency so that the client receives similar comments about the same issue, rather than an array of different descriptions of the same issue depending on which one of many individuals is preparing the lease review.

This same approach can be applied to title review and the review of significant documents. A number of years ago, I was a principal member of a development team that produced an expert system to enable paralegals or law students to review whole residential loans purchased by institutional investors. One of the more significant portions of the system was the review of the land survey and title policy and all of its schedules.

Using innovative approaches like these to accomplish due diligence can help bring more confidence to investors that purchase interests in conduit loans (or any loans for that matter). The fact that a system is available for use that can improve the quality and accuracy of due diligence may raise a question about whether a firm or corporate law department performing the due diligence is exercising due care if it fails to implement or use such a system.

If the Emergency Economic Stabilization Act of 2008 results in the acquisition of a great number of troubled loans from lending institutions, expert systems will enable the due diligence to be performed in a quality manner by a large group of lawyers and paralegals that have not yet developed a great deal of experience in real estate.

Additional uses for expert systems may be in the decision-making processes of the business people when they are confronted with issues raised by the lawyers as a result of the due diligence process. Even though business people are very bright and well educated, they do not always have the necessary experience to make good judgments about whether the issues raised by the lawyers require corrective action or whether the issues may be considered nonmaterial to the subject loan. As mentioned above, business people are subject to great pressure to get their loans closed. Their incentive compensation is based on the volume of business successfully closed (although such compensation arrangements possibly may change as the result of the mortgage crisis). Using an expert system to assist their decision making may prove very helpful, and if the inputs and outputs (or selected portions thereof) from the system are required to be furnished to supervisors, loan committees, auditors, rating agencies, and/or regulators, that could go a long way toward improving the ratings and the confidence in the practices of the mortgage lenders.